UBS' Take On The Swiss Shocker: "The SNB's Standing Is Undermined... There Could Be A Significant Deflationary Shock"

The SNB today dropped the 1.20 EURCHF floor while at the same time lowering the negative interest rate on sight deposits to -0.75% from -0.25% previously, as well as moving the 3m Libor target to between -0.25% and -0.75%. The SNB argues that the floor was an exceptional and temporary measure that 'protected the Swiss economy from serious harm' but that the economy had had time to adjust to the new situation. It continues to argue that the franc had recently depreciated 'considerably' against the dollar. 'In these circumstances, the SNB concluded that enforcing the minimum exchange rate for the Swiss franc against the euro is no longer justified'.

Dramatic market impact

The announcement has had a dramatic impact on markets with EURCHF initially dropping 40% to almost 0.85. It quickly reversed seemingly with the help of SNB interventions at levels just above parity to the euro. The statement noted that 'if necessary' the central bank will 'remain active in the foreign exchange market to influence monetary conditions'. The SMI equity index dropped by more than 8% on the news and has recovered little since. On the rates side cross currency basis moved around another 20bp lower.

Economic repercussions

It would seem likely that today's decision will have significant ramifications in Switzerland as very few observers expected the floor to be dropped with some arguing that it looked set to remain in place for years. Unless EURCHF was to recover back to levels much closer to the old 1.20 floor, the economy could be significantly impacted, as seems well reflected in the reaction of equity prices. At levels close to parity many businesses and investment decisions might not be seen as viable anymore and over time a significant volume of economic production could move outside the country. If so, there could be a significant deflationary shock possibly not too dissimilar to the one Switzerland might have suffered had the floor not been introduced in 2011.

Hope of a limited drop

Where will EURCHF settle after today? The big question is whether investors will want to buy Swiss francs despite substantially negative interest rates and at clearly expensive levels. Nevertheless, safe haven flows have so far demonstrated a remarkable stickiness which can be expected to continue as long as global risk aversion reigns. The SNB might be hoping to be able to stabilise EURCHF at around 1.10 which may be deemed a level that the economy can cope with. However, defending such a level might still be quite costly assuming that global risk aversion continues to linger.

Credibility cost

The other question is about the cost of today's decision for the SNB, both in monetary and credibility terms. The SNB is holding roughly half of their CHF500bn in euros, which implies a loss of possibly not dissimilar to the CHF38bn that the SNB made in profit last year. The monetary impact might thus be manageable. The credibility impact might be harder to gauge though. Domestically, many economic actors relied on what was seen as a 'promise' to hold the 1.20 floor. Internationally, following the negative rates confusion back in December today's decision might be further undermined the standing of the SNB among investors.